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08/09/2010

Plug In and Play: The Current is Flowing in Electric Grid Investing

“When people think about renewable energy, they have visual images of solar panels and windmills,” says Rob Wilder, manager of the benchmark index Wilderhill Clean Energy Index. “They never think about ugly old transmission.” But just as green technology has suddenly made those engineers with pocket protectors the cool guys at cocktail parties, ugly old transmission may well be on its way to becoming the darling of Wall Street.

BRING THE POWER TO THE PEOPLE

In February, Michigan announced its determination to achieve a 45% reduction in fossil fuel consumption by 2020, joining over 30 other US states that have set ambitious renewable energy portfolio standards. Massive investment in a new interstate highway—one that will transport electrons rather than cars and trucks—is a precondition of meeting those targets. That’s because most of the country’s large-scale solar and wind resources are located in places like the Dakotas and southern Arizona, far from the country’s population centers. The high-voltage electric transmission lines required to connect those remote, variable sources of clean power to consumers in Chicago, New York, and Los Angeles simply do not exist today.

“During his campaign Obama barely mentioned transmission at all, but he has surrounded himself with people who understand it well,” says Tom Konrad, an independent renewable energy analyst. For example, Obama’s pick for secretary of the Department of Energy, Steven Chu, has been a vocal proponent of an interstate electric transmission system, potentially financed by a broad base of electricity consumers. With policy makers now acutely aware that state renewable portfolio standard goals can’t be met without this new transmission superhighway, it’s no surprise that the national stimulus package includes almost $14 billion in loan facilities, loan guarantees, and Department of Energy funding not only for renewable energy technology but specifically for the transmission expansion projects required to support clean energy.

But this planned public investment constitutes mere “seed money,” a fraction of what will be required to fully finance new transmission. The Brattle Group has estimated that the United States will need to invest nearly $900 billion in transmission and distribution by 2030 to meet projected growth in electricity demand and state renewable portfolio standards.

SAFETY FIRST

Transmission can’t be built outside the framework of the highly regulated electric power industry, a fact that generates both risks and rewards for transmission investors. Steering a transmission project from the planning boards to completion can take years and can require multiple state and federal regulators to sign off on everything from how the costs are spread to where the wires and poles are sited.

That said, the transmission business does offer a lucrative and dependable stream of income for companies that invest heavily in it and that have investment capital and insider knowledge of the regulatory landscape. “Transmission is a good business to be in once the lines are built,” says Barry Abramson, formerly a utilities industry analyst with Gabelli Asset Management. “You have this regulated monopoly business that earns a good rate of return with little risk. It’s like building a bridge: people have to go back and forth over it and you’re just the toll collector.” That steady income flow from transmission services is looking a lot more attractive in these uncertain economic times.

The FERC (Federal Energy Regulatory Commission), which oversees the interstate and wholesale electricity markets, is offering increasingly generous incentives to spark investment in the country’s aging and inadequate transmission system. These include allowances for enhanced rates of return on equity, accelerated depreciation, and a guarantee of full recovery of “prudently” incurred costs for both construction work in progress and abandoned projects.

THE A-LIST

Matt Farwell, a former alternative energy analyst with Credit Suisse, offers ITC Holdings, the country’s only publicly traded company representing a pure play on transmission, as an example of how FERC incentives can pay off for shareholders. ITC, says Farwell, is in a very “sweet spot.” Building the lines that link renewable energy generators with customers is ITC’s central business strategy, and the company has been able to earn between 12.5% and 14% returns on equity on the operating company level. Through “double leverage,” however, it is effectively earning in excess of 20% on incremental investment.

Neil Kalton, a utilities analyst with Wachovia Capital Markets, explains how that’s possible. Since the rate of return that utilities are allowed to earn under regulatory requirements is tied to the equity base, “the more a utility can finance its capital with equity, the better,” he says. ITC’s three operating utilities each maintain an equity-to-debt ratio of about 60 to 40. ITC shareholders have enjoyed an approximate 13% return on equity from each of those utilities, thanks to FERC incentives. “Separately, at the parent company level, ITC maintains a much more leveraged capital structure of 30% equity and 70% debt,” Kalton reports.

ITC still borrows debt at relatively low interest costs because of the assumption of low risk and reliable cash flow that’s associated with the transmission business. This allows the holding company to infuse that debt into the operating utilities as equity. “If you run the math, that effectively means that on incremental investment ITC is not simply earning 13% but more like 20%,” says Kalton.

In addition to granting ITC enhanced rates of return for its transmission projects, the FERC has also ruled favorably on the company’s requests to recover its expenses and investments in transmission property on certain projects as they are incurred. In the past, utilities could not recover costs from rate payers until projects were completed. These accelerated cost-recovery incentives have been key, since years can elapse before a planned transmission line is actually up and running.

Kalton also views Northeast Utilities as an attractive transmission play. About 50% of Northeast Utilities’ business is transmission related; it plans to invest over $3.5 billion in transmission projects in the next five years. One of its most ambitious propositions is the construction of transmission lines from Canada to southern New Hampshire to bring clean hydropower to a million New England customers. “That will drive strong earnings-per-share growth of approximately 8% annually for the next five years,” says Kalton.

AEP (American Electric Power), a utility known as the “800-pound gorilla of transmission,” may one day spin its transmission business off into a separate entity. AEP operates the largest transmission network in the country and is aggressively forging joint ventures to build the 765-kilovolt lines that will be required for long-distance transmission of variable power. (That said, the strong possibility that the US will soon put a price on carbon emissions, through either a tax or cap-and-trade system, could negatively impact utilities like AEP with substantial investment in coal-fired generation.) Brian Youngberg, senior utility analyst with Edward Jones, notes that Westar in Kansas and PG&E in California are also pursuing major regional transmission projects to bring renewable power to population centers.

THE PUZZLE PIECES

Companies involved in “smart grid” solutions that provide the technology for balancing online capacity and load (supply and demand) on the transmission highway also stand to gain from both transmission modernization and new construction. Itron, a manufacturer of AMR (automatic meter reading) and advanced metering systems, is a leader in the demand response market. “Intelligent meters allow customers to monitor and therefore manage their own real-time energy demand on site,” says Farwell. This allows customers to cut demand at peak hours, which lowers utility bills and takes stress off the grid. The meters also transmit data wirelessly so that a meter reader is not required. Farwell believes that the “market opportunity is attractive and underpenetrated, since globally over 90% of meters are not automated and Itron has a significant market share in AMR deployments.”

Cable and wire manufacturers are also closely tied to the transmission industry. Tom Konrad’s pick is General Cable, a battered-down stock that manufactures transmission and distribution cables. “General Cable seems a sure play because you don’t have to know which transmission projects will be built,” says Konrad. Quanta Services also tops the lists of many analysts who track the transmission industry. A component of Wilderhill Clean Energy, Quanta is a prime contractor to transmission builders. It provides network design, installation, and maintenance services.

“We have been watching the issues in the industry play out for the last seven years,” says Wachovia’s Kalton. “And we think we have reached a threshold—one might say a perfect storm—for transmission development. There is the clean energy theme, with wind becoming an attractive alternative to conventional power, and this economic situation in which building infrastructure, like transmission, is likely to be a big part of the solution. We see this moving forward not as quickly as people may want. But looking out over the next ten years, we will have a very different transmission grid than we have today.”

–Susan Arterian Chang is a financial writer based in White Plains, New York.

This article was originally published in the Spring 2009 Issue of the Investment Professional.